What Pimco's 'Paranormal' Means for Pension Funds

Bill Gross of PIMCO participates in a conference on the future of housing finance at the Treasury Department in Washington, DC.

The new "new normal" is a "paranormal" market — and this paranormal market could wind up haunting pension funds.

The description of the market as "paranormal" comes from the latest note from Bill Gross, the founder and managing director of Pimco.

"The financial markets are slowly imploding — delevering — because there’s too much paper and too little trust. Goodbye 'Old Normal,' standby to redefine 'New Normal,' and welcome to 2012’s 'Paranormal,' Gross wrote in his "Investment Outlook" letter for January.

Gross says the reduction in debt in the household sector has been met with the growth of debt in the government sector. Basically, debt has shifted from households to state treasuries. This leaves us in a position of facing two diametrically opposed risks: inflationary growth fueled by more government credit expansion or contractionary deleveraging of the public sector. What's more, zero-bound interest rates may be slowing global growth by disincentivizing banks from lending.

"For 2012, in the face of a delevering zero-bound interest rate world, investors must lower return expectations. Two percent to 5 percent for stocks, bonds and commodities are expected long-term returns for global financial markets that have been pushed to the zero bound, a world where substantial real price appreciation is getting close to mathematically improbable," Gross writes.

If Gross is right, public pension funds may be dramatically more underfunded than is currently understood. Government's typically assume that they will earn an 8 percent return on money they put into their pension funds. When the funds earn substantially less than that, they wind up with shortfalls that mean they cannot pay out promised benefits.

Pension fund managers have assumed 8 percent annual returns, because that is what they earned in the past few decades. But if the market has shifted into the paranormal, where investors should expect returns of just 2 percent to 5 percent, we're facing a pension fund catastrophe. Even at the upper end of Gross's return, pension funds would have shortfalls in the trillions of dollars.

The underperformance of pension funds also creates incentives for fund managers to "chase yields" by going after riskier and less liquid investments, such as hedge funds and private equity funds. They are already big contributors to alternative investments but, to earn 8 percent, they may have to dedicate even more of their portfolio to alternatives. As I reported last May, this is exactly what the managers of hedge funds and private equity funds think will happen.

It's part of the business plans of most of the biggest private equity funds.

"More and more money is likely to go into private equity, particularly from the public pension funds," the Carlyle Group's David Rubenstein saidat the Milken Institute's Global Conference in May.

The problem is that there is a reason why risky assets are called "risky." They entail risk.

Mebane Faber, who describes pension funds going into alternatives as adopting an "Endowment Model," explained the problem in a July posting for NetNet.

Unfortunately, most pension funds are not prepared for lengthy bear markets, because they are seen as extraordinary and beyond the scope of either feasible response or possibility. But we only need to look at post-1980s Japan to see that long-running bear markets can occur in even the most sophisticated economies.

Over the past two decades, a Japanese pension fund manager who chose an endowment-style strategy would have returned just 1.42 percent per year — far less than the Japanese government bond return of 4.36 percent per year. The fund would have lost a whopping 4.62 percent per year had the manager chased higher returns by investing in equities over the same time period.

What these returns show is that by diversifying away from bonds and into risky assets, the endowment-style portfolio has the potential to perform better, but also worse than the risk-free rate in a perpetual bear market. Paradoxically, in an effort to meet the universal 8 percent assumed rate, pension funds may be laying the groundwork for returns even lower than the risk-free rate.